There are lot of questions that arise in the mind of a newbie investor, like where should I invest, which asset class will generate good returns, which is less risky and how can I diversify my portfolio while minimizing the cost. We all know diversification is the key to minimize the risk. So first, we should know about various options available for investment and choose the combination of assets that will make our portfolio look quite lucrative. Broadly, investments are divided into two types: - Traditional Investments & Alternative Investments. Now let’s see few types of alternatives and how they are differentiated from traditional investment.
As the name suggests, traditional investments are those types of investments that are popular as well as commonly used by many retail investors. It involves investing in well- known assets that are easily available to an individual. The market for Traditional Investments in India is matured. Traditional investments have enough liquidity and are highly regulated by Securities Exchange Board of India (SEBI). Traditional investments consist of Stocks, Bonds, Fixed Deposits, Physical Gold, Public Provident Fund and various types of pension schemes.
Alternative Investment is an investment in assets other than stocks, bonds, gold etc. Managers often use leverage to invest in alternative assets. Historically alternative Investment have had low correlation with those of conventional investments over long period of time. In recent years, Alternative Investment Funds have gain popularity among many High Net worth Individuals because of diversification benefit that it offers and also the potential to generate excess returns when compared to stocks and bonds.
Alternative Investment includes investment in tangible assets like Commodities, REITS, Paintings, Wines, Precious metals or in Financial assets like Private Equity, Hedge Funds, Distressed Debt and Crypto currency.
Some popular Alternative Investments can be described as:- PRIVATE EQUITY
Private Equity funds are those funds that pool capital from investors who want exposure to private and high growth potential companies. Usually, the capital is raised from Institutional Investors or HNIs. The investment horizon of a PE ranges from four to seven years. The motive of PEs is often to gain control or influence over the company’s operations. As of 2018, AUM under Private Equity were $3.41 trillion and is expected to grow around 58% to $4.9 trillion, highest AUM among other alternatives. Some strategies used by Private Equity are Leveraged Buyouts (LBOs), Venture Capital, Distress Investing. They can cash out their investment in three ways: - IPO, Recapitalization or Merger & Acquisition.
Hedge fund is also pooling of money from various accredited investors, where the funds are managed by professionals who use leverage and invests in various liquid or illiquid assets by deploying different types of strategies. Investment in a hedge fund gives flexibility with investment options where one can earn higher Return on Investment (ROI) by reducing overall portfolio risk. It is projected that increase in AUM of Hedge Funds is expected to grow by 31% from $3.6 trillion to $4.7 trillion by 2023. Different types of strategies that are used to hedge one’s position are Event Driven strategies, Macro strategies, Equity Hedge Fund strategies and Relative Value strategies.
Globally, the market of PE and Hedge Fund is highly specialized. In India, Private Equity comes under category II and Hedge Funds under category III of Alternative Investment Fund (AIF) .These AIFs are registered and approved by SEBI. If an individual wishes to invest in these, can invest through different categories of AIFs where the minimum investment starts from Rs.25 Lakh and can go up to Rs.1 crore with minimum tenure of 3 years.
Now let’s have a look on factors that differentiate Alternative Investments from Traditional Investments:-
Liquidity – The main difference between these two types is liquidity. Liquidity is said to be an important factor while investing in any asset. Traditional investments have very high liquidity compared to alternative investments as it is traded on public market where one can easily redeem their position in stocks or bonds in order to get cash.
Fee Structure – As alternative investments require a minimum investment amount and are managed by professionals they are subject to annual management fees ranging between 1%-2% of the committed capital and high incentive fees up to 20% of the profits, whereas in case of traditional investments like mutual funds it has minimal entry & exit loads and require a negligible investment amount.
Risk & Return – When it comes to risk factor, investments made in startup, private debt or in Intellectual property are very high as it is done at the very early stage of the growth, but it gets compensated by higher returns over a period of time. While traditional investments are a safe bet, they are less risky and generate lower returns compared to alternatives.
Regulation – Since most of the alternative investments are not publicly traded they are less compliant and does not much come under the regulation of SEBI. But unlike alternative investments, conventional vehicles are under strict regulations and have to properly comply with the rules and regulations issued by SEBI.
Transparency – Transparency also plays an important role while investing as it allows investors to know how the management is able perform their duty towards their shareholders and accordingly investors can do proper due diligence before investing. Traditional investments are completely transparent whereas Alternatives seems to be less transparent which creates difficulty in getting historical data of the fund or the previous performance of the fund manager.
WHERE SHOULD YOU INVEST YOUR MONEY?
As we can see, there are some big differences between the two. However, there is no real way to decide which investment type is best. Since there are so many types of investment vehicles, it is normal for an investor to get overwhelmed and someone new to investing would find it difficult where to invest their money without making any wrong investment choice, so for that purpose one has to keep in mind some factors like his Age, Investment Horizon, Risk profile, Liquidity needs and Income status before investing in any type of asset. Everything depends on how you want to invest and what option appeals to you more. Creating a portfolio with only traditional assets or only alternatives will not help you to generate abnormal profits or mitigate any risk. Instead, it will expose you to high risk and lead to more than expected loss during financial distress as your portfolio will not be diversified. Perhaps the sensible way to reduce the risk is to diversify your portfolio; with a little bit of both Traditional and Alternative investments.
Alternative investments like commodities and real estate acts as hedge of inflation risk, adding it in your portfolio will give you some cushion in case of Equity market falls drastically. They are also less then perfectly correlated with equity or bond market which will increase your expected returns over time and make your portfolio look more efficient.
After knowing about both traditional & alternative investments it can be concluded that combination of steady & high risk investments in a portfolio can accumulate a higher net worth and build a comfortable portfolio in long duration. Therefore one should do proper due diligence before investing in any of the asset.